Thursday, August 30, 2007

How Deflation Orthodoxy Got Us Here

In a previous posting I claimed that that one of the reasons for current financial quagmire is that the Federal Reserve's response to the deflationary pressures of 2003 failed to account for the possibility of benign deflation. Rather, the Federal Reserve assumed the deflation was of the malign or harmful form and pushed the real federal funds rate into negative territory. What I want to do now is (1) discuss more fully the differences between malign and benign deflation and (2) then consider why this distinction matters for macroeconomic stability. (Some of this material I have borrowed from my recent article, The Postbellum Deflation and Its Lessons for Today. )

Malign DeflationMost observers view deflationary pressures as a threat to macroeconomic stability. This understanding of deflation is often justified by noting several important channels through which deflation can adversely affect an economy. First, given relatively rigid nominal input prices, an unexpected decline in the price level will increase real input prices, lower firms’ profit margins, and as a result reduce production and employment levels. Second, the nominal interest rate may be pulled down by deflation to its lower bound of zero and thereby eliminate the possibility of additional monetary stimulus through the policy rate. Third, the financial system will become beset with unplanned increases in real debt burdens as the price level falls as well as unanticipated decreases in collateral values as the economy deteriorates. As a result, delinquencies and defaults will increase and the balance sheets of financial institutions will weaken. In turn, financial intermediation will suffer and create and additional drag on the economy. Collectively, these events may reinforce each other in a ‘deflationary spiral’ where expectations of more deflation and additional economic weakness lead to a further fall in aggregate demand pushes the economy into a prolonged economic slump.

Benign DeflationThis conventional view of deflation, however, assumes deflation is the result of negative shocks to aggregate demand and fails to consider that deflation may also arise from positive shocks to aggregate supply that are not fully accommodated by monetary policy easing. This benign form of deflation occurs as the result of productivity advances that lowers per unit costs of production and in conjunction with competitive forces, puts downward pressure on output prices [1]. Profit margins are likely to remain stable under this form of deflation even if relatively rigid nominal input prices, such as wages, are present since the decline in output prices is matched by the decline in per unit costs of production. The productivity gains also mean an increase in the natural rate of output and the real interest rate. In turn, the higher real interest rate should counter the downward pressure on the nominal interest rate from the deflationary pressures and minimize the chance of hitting the lower nominal interest rate bound. Financial intermediation should not be adversely affected either, since the burden of any unanticipated increase in the stock of real debt arising from benign deflation should be offset by a corresponding unanticipated increase in real income, while collateral values should not decline but increase given expectations of higher future earnings from the productivity growth. Deflation, therefore, can be consistent with economic growth and should not always be feared.

([1] Aggregate supply induced-deflation can also arise as the result of positive factor input shocks with many of the same implications as noted above.)

Why the Malign-Benign Deflation Distinction MattersImagine the U.S. economy is buffeted with a series of positive productivity shocks that increases aggregate supply. This development would put downward pressure on the price level and set off the deflation red alert sign at the Federal Reserve. Now, in order to keep the price level from falling, the Federal Reserve must act to increase nominal spending. If this change in monetary policy were unexpected, or if there were significant nominal rigidities (i.e upward sloping Short-run aggregate supply curve), the nominal spending increase that stabilizes the price level would also push actual output beyond its natural rate level. Hence, there would be both a sustainable component—the productivity gains—and a non-sustainable component—the monetary stimulus—to the subsequent increase in real output. Moreover, the unsustainable pickup in actual output would occur without any alarming increases in the price level making the real economic gains appear macroeconomically sound. The increase in nominal spending could thus create a boom-bust cycle in real economic activity without any of the standard inflationary signs of overheating.... sound familiar?

These developments could also be viewed from an interest rate perspective. Here, the Wicksellian view that the actual real rate of interest can deviate from the natural rate of interest in the short run is invoked. The natural rate of interest is the real interest rate justified by non-monetary fundamentals, specifically the productivity of capital, the labor supply, and individuals’ time preferences and is the real interest rate consistent with the natural rate level of output. Recall that an increase in the growth rate of productivity should be matched by a similar increase in the natural rate of interest. If, however, monetary authorities attempt to offset the productivity-generated deflationary pressures by lowering the policy interest rate, they may force the actual real interest rate below the natural interest rate. This response can create an unsustainable credit boom. The resulting macroeconomic disequilibrium will be manifested in unwarranted capital accumulation, excessive leverage, speculative investments, and inordinate asset prices...again, sound familiar?

Here is a figure from an earlier posting on this topic. Given the above discussion, it should be evident from this figure that the Federal Reserve's response to the 2003 deflation scare was hugely distortionary. Had the Federal Reserve not been a slave to the deflation orthodoxy and considered the possibility of benign deflation where would we be today?

No doubt the Fed was thinking aggregate demand was weakening, especially after coming out of the jobless recovery you mentioned. But there were observers at the time who suggested that maybe the low inflation was coming from the rapid productivity gains. For example, Gary Stern, the President of the Minneapolis Fed, questioned the Fed's response and its misguided fear of the 2003 deflationary pressures (see http://www.minneapolisfed.org/pubs/region/03-09/top9.cfm). Why didn't his views get more hearing?

There appears to be a collective economic psyche shaped by the horrific (malign) deflation of the Great Depression and Japan's more recent (malign)deflation experience that simply does not allow most observers to consider the possibility of benign deflation.